Commodities trading, Adam Smith wrote in 1776, was a boon to efficiency and a foe to famine. It was also extremely unpopular, especially in years when harvests were poor (he was writing specifically of trading in corn).

The popular odium ... which attends it in years of scarcity, the only years in which it can be very profitable, renders people of character and fortune averse to enter into it; and millers, bakers, mealmen, and meal factors, together with a number of wretched hucksters, are almost the only middle people that ... come between the grower and the consumer.

Since then, trading in corn and other commodities has gained in respectability — thanks in part to arguments and evidence mustered by economists following in Smith's footsteps. But the suspicion that commodities trading is dominated by wretched hucksters or worse (I don't know what "mealmen" are, but they sure sound bad) has never gone away, with David Kocieniewski's epic examination in Sunday's New York Times of an aluminum storage business owned by Goldman Sachs offering the latest bit of evidence. Kocieniewski describes forklift drivers moving aluminum from warehouse to warehouse in Detroit to profit from rules set by an overseas metals exchange, while delivery times to actual users of aluminum have stretched to 16 months and aluminum prices have been pushed up by the equivalent of a tenth of a U.S. cent per aluminum can.

The article is less clear about what brought this on. Is it bad rules set by the London Metal Exchange? The involvement of banks such as Goldman and J.P. Morgan in the metals trade? Or is the problem simply that speculators have taken over the market for a crucial commodity?

It is certainly true that investors, dismayed at the prospect of low returns for stocks and bonds for years to come, have poured money into commodities over the past decade. Markets that existed mainly for the convenience of industry have become dominated by exchange-traded funds, hedge funds, and investment banks.

By Adam Smith's reasoning, this shouldn't be a bad thing — people of character, or at least fortune, are getting into the trade. And the consensus among economists has for decades been that commodity speculation clearly serves a useful purpose — so more of it can't hurt, right?

The evidence on this is, frustratingly, not nearly as conclusive as one might hope. The most famous studies have had to do with trading in onion futures, which the Chicago Mercantile Exchange launched in the 1940s and Congress banned in 1958 after a precipitous boom and bust. Agricultural economist Holbrook Working proposed at the time that this presented the opportunity for a natural experiment: if onion prices were more volatile in the absence of futures trading, then the trading probably served a useful economic purpose. If not, then maybe it didn't. The first post-ban study, published in 1963, did indeed find such an effect, and has since been cited widely by economists and editorialists. A 1973 followup, however, was inconclusive.

When economist David S. Jacks of Simon Fraser University reviewed this evidence a few years ago along with before-and-after data from when futures trading in various commodities started, he still concluded that "futures markets are systematically associated with lower levels of commodity price volatility." So, on balance, having a futures market appears better than not having a futures market.

What this doesn't tell us, however, is whether certain kinds of commodity futures and spot markets are better than others, or certain kinds of traders are better than others. There's at least some evidence from the great commodities boom of the past decade that the new dominance of financial investors has made a difference, and not necessarily for the better. Three recent research findings:

Marco J. Lombardi of the European Central Bank and Ine van Robays of Ghent University found that "financial investors did cause oil prices to significantly diverge from the level justified by oil supply and demand at specific points in time."

Lucia Juvenal and Ivan Petrella of the St. Louis Fed found that speculative forces began to drive oil prices in 2004, "which is when significant investment started to flow into commodity markets."

Ke Tang of Renmin University of China and Wei Xiong of Princeton University found that prices in non-energy commodities have begun to move in tandem with oil prices, and have become more volatile.

None of these studies blamed speculation for causing all or even most of the price movements. It seems pretty clear that the big rise in oil prices since 2003 has been driven by fundamental forces of supply and demand. But the new commodities market participants may have made things worse, as Kocieniewski's aluminum findings seem to show.

So what's the solution? I'm guessing it has something to do with adjusting the rules of the game. Commodities-trading rules and customs that date back to the pre-financial era may not fit the more aggressive tactics of hedge funds and investment banks. The London Metals Exchange is already in the midst of changing its warehousing rules, with hard-to-foresee consequences. The Commodity Futures Trading Commission has started using new powers granted it under the Dodd-Frank Act to go after traders whose behavior it deems abusive. And in general, we're in the early stages of a long struggle to put the financial sector back in the position of servant of the economy rather than its master.

Speculation is, on balance, a good thing. But more of it isn't necessarily always better — and it's too important to leave entirely in the hands of the wretched hucksters.

I don't believe speculation hurts anyone but the speculator who speculates incorrectly. Now, "rules" governing exchanges may affect prices or create perverse incentives, but that's a different issue. Speculation provides liquidity essential to fair pricing, which in turn provides concrete signals to market participants that is essential to efficiency.

Quite frankly, I'm not even sure how to define "speculation" - to some, I'm sure making any investment is "speculation." Taken to the extreme, getting an education or a trade license is speculative. The term itself almost always seems to be intended as a boogeyman.

................"By betting on the price outcome with only a single futures contract, a speculator has no effect on a market. It's simply a bet. But a speculator with the capital to purchase a sizeable number of futures derivatives at one price can actually sway the market. As energy researcher F. William Engdahl put it, "[s]peculators trade on rumor, not fact" [source: Engdahl]. A speculator purchasing vast futures at higher than the current market price can cause oil producers to horde their commodity in the hopes they'll be able to sell it later on at the future price. This drives prices up in reality -- both future and present prices -- due to the decreased amount of oil currently available on the market.".........

.................”As a result of speculation among these and other major players, an estimated 60 percent of the price of oil per barrel was added; a $100 barrel of oil, in reality, should cost $40 [source: Engdahl]. And despite having an agency created to prevent just such speculative price inflation, by the time oil prices skyrocketed, the government had made a paper tiger out of it.”.........

You can sum up any active fund manager’s presentation at an investor conference in one sentence: “We’re doing well, all things considered.”

Bradley wrote:I believe there is clear and convincing evidence that speculators do make things cost more.

That's not clear and convincing evidence.

The speculators can't eat that oil. They have to sell that oil at some point, either back into the commodities markets, or directly to someone who uses the oil. This would then drive prices down by a corresponding amount. It's easy to be angry at speculators when you're paying $100 for oil that should cost $40. But nobody gives thanks to speculators when they're paying $100 for oil that should cost $160.

This is why economists look at volatility over time, rather than just a snapshot of the current price. Does speculation dampen volatility, by buying when prices are low and selling when prices are high? Or does it have no effect? It cannot aggravate volatility in the long-run, because this would mean buying when prices are high and selling when prices are low -- which would eventually drive speculators into bankruptcy. (Of course, anything can happen in the short-run.)

Of course, there have to be safeguards. For example, you don't want someone cornering the market for a commodity.

talzara wrote:The speculators can't eat that oil. They have to sell that oil at some point, either back into the commodities markets, or directly to someone who uses the oil. This would then drive prices down by a corresponding amount. It's easy to be angry at speculators when you're paying $100 for oil that should cost $40. But nobody gives thanks to speculators when they're paying $100 for oil that should cost $160.

Prices, in a free economy, are set by supply and demand. When you artificially create hundreds of $billions in demand through commodity funds/CCfs you distort the markets true price discovery mechanisms. Price increases in the future markets, especially the longer dated future contracts are transmitted to and affect the prices in the actual commodity markets. Commodity index funds do not trade on the basis of supply and demand fundamentals or in response to liquidity demands. Rather, they trade on the basis of investment inflows and the need to perpetually roll contracts forward as they expire. This type of activity can/does distort supply and demand mechanism leading to increases in volatility which imposes direct costs on businesses legitimately using the markets to manage price risk. These costs become a cost of production, directly increasing prices. Below are two references which may be of interest.

“Regulators need to take a “long, hard look at the practice of banks holding physical commodities,” Brown said in a statement before the hearing. JPMorgan’s decision to consider selling or spinning off its commodities business is “good news for consumers and taxpayers,” he said in an e-mail yesterday.............................................................................The congressional inquiry came three weeks after the London Metal Exchange said it wants to help unclog growing queues at repositories, which companies ranging from beer makers to wire fabricators say have reduced the availability of aluminum and copper.

You can sum up any active fund manager’s presentation at an investor conference in one sentence: “We’re doing well, all things considered.”